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    Traditional Approach

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    Traditional Approach

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    5 views7 pages

    Traditional Approach

    Uploaded by

    archishamehta7

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    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
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    You are on page 1of 7

    Unit 2: Capital Structure Theories

    Traditional Approach
    Traditional
    • Approach
    The NI approach and NOI approach hold extreme views on the
    relationship between capital structure, cost of capital and the
    value of a firm.
    • Also known as intermediate approach, is a compromise
    between the net income and net operating approach
    • According to this approach, the cost of capital declines and the
    value of the firm increases with leverage up to a prudent debt
    level and after reaching the optimum point, coverage causes
    the cost of capital to increase and the value of the firm to
    decline.
    • According to the traditional approach, value of a firm can be
    increased or the cost of capital can be reduced by judicious
    mix of debt and equity capital can increase the value of the
    firm by reducing overall cost of capital up to certain level of
    debt.
    • The value of the firm can be increased initially or the cost of
    capital can be decreased by using more debt as debt is a
    cheaper source than equity. Thus , a optimum capital structure
    can be reached by a proper debt equity mix.
    • Beyond a particular point the cost of equity increases because
    increased debt increases the financial risk of equity
    shareholders.
    • Thus overall cost of capital decreases up to a certain point,
    remains more or less unchanged for moderate increase in debt
    thereafter and increases or rises beyond a certain point
    • Stage 1: As per Ezra Solomon:
    First Stage: The use of debt in capital structure
    increases the ‘V’ and decreases the ‘Ko’.
    • Because ‘Ke’ remains constant or rises slightly with debt,
    but it does not rise fast enough to offset the advantages
    of low cost debt.
    • ‘Kd’ remains constant or rises very negligibly.
    • Stage 2: after the firm has reached a certain level of leverage,
    increases in leverage have a negligible effect on the value, or
    cost of capital. This is so because of increase in cost of
    equity due to the added financial risk, just offsets the
    advantage of low cost debt WACC will be minimum and the
    maximum value of the firm will be obtained
    • Stage 3: beyond the acceptable limit of leverage, the value of
    firm decreases with leverage or the cost of capital increases
    with leverage. This happens because investors perceive a
    high degree of financial risk and demand a higher equity
    capitalization rate which exceeds the advantage of low cost
    debt.
    Criticism of
    traditional
    • approach
    Validity of the traditional view has been questioned on the
    grounds that the market value of firm depends upon its
    net operating income and risk attached to it.
    • Criticised because it implies that totality of risk incurred by
    all security holders of a firm can be altered by changing the
    way in which this totality of risk is distributed among various
    classes of securities.
    • Modigilani and Miller criticised the assumption that Ke
    remains unaffected by leverage up to some reasonable limit.
    They assert that sufficient justification doesn’t exist.
    THANK
    YOU

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